FULL REPORT: Invest in a Slice of Chuck E. Cheese Early for Growth at a Discount

What’s virtually immune to the economy, technological change, and the Amazon effect? The need to get children out of the house every now and then.

Perhaps the best way to bet on that phenomenon is investing in Chuck E. Cheese, a children’s entertainment destination and restaurant founded in 1977 whose prospects are stronger than ever. Chuck E. Cheese’s parent, CEC Entertainment, plans to go public through a merger with Leo Holdings (ticker: LHC), a blank-check company or SPAC that raised money to find a target. The last major hurdle is getting the majority of LHC shareholders who cast votes to approve the deal at an upcoming extraordinary general meeting, expected in July, after which the ticker will change to “CEC.”

The first factor investors should note is Chuck E. Cheese’s historical resilience. Even when many retail businesses saw deep, double-digit sales freefalls, the business eked out positive same-store sales in the early 90s oil shock, the dot com bust of the early 2000s, and the great recession of 2008-2010. The key is an incredibly strong brand among children and parents along with a straightforward concept of playing games for tickets that are redeemed for prizes – which has worked for multiple generations despite cultural and technological change.

Now, the company is on course to grow even faster. Under private ownership of private-equity giant Apollo Global Management, Chuck E. Cheese began to address an unlocked opportunity: Getting adults to say “yes” more often when kids wanted to go (basically all the time).

To do so, Chuck E. Cheese locations underwent renovations that not only gave them a newer appearance, but also added features that made adults more inclined to stick around. For instance, locations now offer Wi-Fi and alcoholic drinks for parents, with a strict maximum of two per visit. The menu also expanded to include more adult-friendly food options and the latest version of pizza, which is made from scratch in house, has topped Pizza Hut in a nationwide taste test.

The result has been a big boost in average unit volumes at remodeled locations, which generate $1.8 million per year. In 2018, the company remodeled 25 Chuck E. Cheese locations, which experienced an average 16.5% same-store sales improvement versus the core locations. Some 480 locations have yet to be remodeled, with 60 slated for completion in 2019 and 90 per year thereafter.

There’s plenty of room to increase the average spend per visit while keeping Chuck E. Cheese within reach across most household income brackets. Currently, the average spend is less than $40 per visit. That compares with family trips to a movie theater which can easily run over $100.

It’s also important to note that Chuck E. Cheese sits in an unusual intersection of entertainment and dining. That makes it a more popular place to bring children when parents need both food and fun for their kids. Since games and prizes have relatively low costs to the company, the overall business sports an 85% gross margin, considerably higher than a restaurant that’s focused mainly on food and drink.

That margin could increase further thanks to a new “all you can play” offering that allows guests to play for fixed time periods rather than using credits. That option, which has resonated with parents, increases the mix of revenue further towards entertainment versus food, which should boost overall margins yet higher.

The international opportunity also shouldn’t be overlooked. Pizza and games for children tend to resonate across geographies, cultures, and religions. The company already has an international footprint with 108 locations ranging as far as Mexico and Saudi Arabia and has future commitments for another 82 locations, many of them in locales even further afield. Those franchises boost margins because the company collects a fee rather than owning and operating locations itself.

Looking further ahead, there’s scope to consider licensing the incredibly strong Chuck E. Cheese brand for apparel, toys, or even movies. And as CEC has shown with the 2014 purchase of Peter Piper Pizza, whose Ebitda has since risen 35%, it’s possible to scoop up complementary brands and find synergies right away.

In a sign of commitment to the company, Apollo will retain 51% of the stock after the deal closes. Apollo also retained a stake in Hostess Brands for a while after the company went public through a SPAC in 2016. Hostess has since traded well, rising more than 40%.

In the case of CEC, Apollo is putting two directors on the board of the public company. One of them, Andrew S. Jhawar is a Senior Partner and Head of the Consumer & Retail Industry team at Apollo and will serve as co-chairman of CEC. That has become a popular decision among private equity firms using SPACs to take companies public, including Corsair Capital, which plans to keep members on the board of fintech company Repay as well.

Equally important, Thomas Leverton, who has been CEO since 2014, will remain at the helm as the company goes public. Mr. Leverton has led the company to a higher growth trajectory and has strong track record in the industry, having previously run TopGolf, a golf entertainment company.

There’s good news for investors who want to own CEC: It’s not expensive – yet. Shares of Leo Holdings trade around $10.25 apiece or about 7 times 2020 forecast Ebitda, which is expected to grow at around 10% for the next few years. By comparison, Cheesecake Factory trades at 8.4 times, Six Flags at 11.2 times, and SeaWorld Entertainment at 8.5 times, according to Sentieo.

Other recent SPAC deals have performed extraordinarily well after they were approved and more investors took notice. Health and wellness company OneSpaWorld (ticker: OSW), formerly Haymaker Acquisition Corp., has surged more than 50% to a recent price of $15.35 a share from around $10 a share shortly before the deal was approved earlier this year.

The near-term downside is limited as well. Based on strong trading of LHC warrants (ticker: LHCW), it looks likely the deal will be approved. But if it isn’t, shareholders would receive roughly $10 per share in cash back.

Of course, there is always execution risk when revamping restaurants. But much of the complex, risky changes have already been made while the company was in private hands. Investors would be wise to take a bite of LHC before the price of admission goes up.